Some of the finest infrastructure
to be found between Singapore and Dubai lies in the south of Sri Lanka, close
to the crashing waves of the Indian Ocean. Broad highways connect a deep-sea
harbour to a silvery, angular convention centre and, further inland, to an
elegant airport terminal with vaulted wooden ceilings. But it does not take
long for visitors to see that something is awry. Wild peacocks scampering
across the roads easily outnumber the people using the state-of-the-art
facilities. The port sees less than a ship per day and the airport, which has
been open for three years, no longer offers regular flights. The Sri Lankan
government’s debt on the complex runs to at least $1.5 billion, or nearly 2% of
the country’s GDP. And almost all of that is owed to Chinese banks.

Sri Lankan officials are careful
not to blame China for the mess. It was the previous president, Mahinda
Rajapaksa, who wanted all these facilities built near his home town of
Hambantota, even though there was little commercial justification for them. But
privately they feel that the lender must also bear responsibility. Were it not
for Chinese banks extending vast amounts of credit with minimal safeguards, Sri
Lanka would never have been saddled with these debts. Moreover, the Chinese
banks charged unusually high interest rates on at least some of the loans. The
term “odious lending” comes to mind, says a Sri Lankan government adviser. Partly
because of its debt load and big looming repayments, Sri Lanka turned to the
International Monetary Fund this year for a bail-out.

Tracking the ways in which the
Chinese financial system affects the global financial system is far from
straightforward. Since China is the world’s biggest trading nation, the fate of
its economy clearly affects most of the globe. The slowdown in its construction
industry has already battered commodity exporters from Mongolia to Brazil. But
direct financial connections between China and the rest of the world are much
more limited. In China, itself regulations cap the involvement of foreign
institutions, and Chinese banks, insurers and brokerages have been remarkably
diffident about expanding abroad. Nevertheless, the promise and the problems of
China’s financial sector are rippling beyond its borders.

As Sri Lanka can attest, one
crucial, if often overlooked, linkage is China’s funding for other emerging
markets. At the end of last year, the combined overseas loan book of China’s
two leading development lenders, China Development Bank and Export-Import Bank
of China, reached $550 billion, a multiple of the World Bank’s roughly $150
billion. Some of that lending has gone to Chinese firms doing business abroad,
but the bulk has been for governments and companies in developing countries.

It might seem churlish to criticise
China for lending to poor countries, but loans are not gifts. The recipients
have to repay them, so it is fair to ask whether they are getting a good deal.
The evidence is mixed. China’s money has built many useful things, including
power stations, roads, dams and railways across Africa, Latin America and South
Asia. It has also offered a lifeline to emerging markets suffering capital
outflows. Last year, China’s two development banks lent $29 billion to hard-hit
Latin American governments, three times as much as in 2014, according to the
Inter-American Dialogue, a Washington think-tank.

But Chinese money is part of what
got these countries into trouble in the first place. Its development banks have
exported some of the worst excesses of the Chinese financial system: lending
out huge dollops of cash with few strings attached, other than that Chinese
contractors must do much of the construction. In the case of the airport and
port in southern Sri Lanka, officials say there was insufficient analysis of
their viability and no competitive bidding. “Would it have been bad to insist
on these conditions? These are things we needed to do,” says Harsha de Silva, a
critic of the original loans who is now deputy foreign minister. Allegations of
corruption and waste have also followed Chinese loans around from Pakistan to
Angola, Ecuador and Venezuela.

There are some signs that China
wants to mend its ways. It has started being tougher on loan recipients, and is
hoping to emulate the World Bank’s best practices in running the Asian
Infrastructure Investment Bank, a multilateral lender it established last year.
Yet the legacy of the past decade is that a number of poor countries are now
deeply in debt to China, sometimes with little to show for it. China, to its
credit, has so far been accommodating to those in trouble, extending maturities
and providing new financing. But if China itself hits the skids and loses more
foreign-currency reserves, it will have fewer dollars to spare for others. That
would make the outlook for those already in hock to China even grimmer.

For advanced economies, the picture
looks very different. Chinese banks have only a minor presence there, so the
dangers of a China-led credit crunch are much smaller. At the end of last year
overseas loans by Chinese commercial banks totalled just $410 billion, less
than half the loan portfolio of Wells Fargo, America’s largest bank by market
value. Chinese banks have been wary about making international acquisitions
after ill-timed investments by China Investment Corp, a sovereign-wealth fund,
just before the global financial crisis. Industrial and Commercial Bank of
China’s $690m purchase of the London-based trading unit of South Africa’s
Standard Bank is one of the most ambitious overseas forays by a Chinese bank
ever – yet it is worth less than 0.03% of ICBC’s assets.

Whatever happens to the domestic
economy, it seems inevitable that Chinese financial institutions will increase
their weight in developed markets in the coming years. If growth in China holds
up well, they will have even more cash to deploy abroad; if their own economy
stumbles, they will have an extra incentive to look abroad. For now, less than
3% of Chinese banks’ 102 trillion yuan in loans are in foreign currencies. Just
serving Chinese companies as they venture abroad will ensure a big increase:
they have accounted for nearly a third of all global cross-border M&A deals
so far this year, according to Dealogic. Of Chinese insurers’ 13 trillion yuan
in assets, a mere 2% are currently overseas. Insurers are starting to grab
headlines with their overseas investments, such as Ping An’s acquisition of the
Lloyd’s building, a London landmark, and Anbang’s bid for Starwood Hotels &
Resorts, owner of the Sheraton and Westin brands. More are sure to follow.

In some ways, this is to be
welcomed. Over the past 15 years China has transformed earnings from its trade
surplus into foreign-exchange reserves, most of which in turn were stashed away
in American government bonds, which are safe but low-yielding. Foreign
investment and overseas acquisitions, if well managed, are a more productive
use of China’s savings.

Yet these outbound forays also
harbour serious dangers. In the vanguard are state-owned enterprises, many of
which are already leveraged to the hilt at home. Take ChemChina, a chemicals
giant that bid $44 billion for Syngenta, a Swiss rival, earlier this year. If approved,
this will be China’s biggest overseas takeover in history. Yet ChemChina’s
debt-to-equity ratio is 234%; Syngenta’s is a much more conservative 44%.

In normal circumstances, banks
might be reluctant to fund companies already carrying so much debt. But Chinese
banks are only too willing to back SOEs, especially when international
expansion is part of their national mission. Foreign banks, too, assume that
government support for SOEs is rock-solid. These deals are spreading China
Inc’s indebtedness to foreign markets; the balance-sheets of its acquisition
targets will become much more vulnerable to a downturn in growth.

Mercifully, direct global exposure
to the dangers within China’s financial system is still small for now. That is
thanks in large part to a regulatory wall around the economy: foreigners can
own no more than 20% of local banks, and can invest in stocks and banks only
through strictly controlled channels. As a result, foreign investors own just
around 1% of the Chinese stock market and even less of the bond market.

International banks, for their
part, account for only 1.5% of total commercial bank assets in China. More than
half of those assets are concentrated in the hands of three institutions: HSBC,
Standard Chartered and Singapore’s OCBC Wing Hang, according to KPMG. Several
others, including Goldman Sachs, Bank of America and Citi, previously had large
investments in Chinese banks but sold them for chunky profits in recent years.

For foreign banks with big
operations in China, its slowdown clearly poses risks. Standard Chartered got a
taste of that in 2014, when it set aside about $175m to cover losses incurred
in lending to a Chinese trading company, which had pledged the same stockpile
of metals as collateral many times over to different banks. That scandal also
dragged in Citi, HSBC and others. But they have generally been careful, partly
because they have no alternative. Chinese banks, with their deeper local
connections and rapid lending, have scooped up the vast majority of domestic
clients, including the most indebted ones. Foreign banks, by and large, still
serve international companies, which are among the safest borrowers in China.
“The joy of being a drop in the ocean is that you can choose your drop in the
ocean,” jokes one foreign veteran.

The next few years could bring
dramatic changes on multiple fronts. Regulators have opened new channels for
foreigners to invest in stocks, creating a link between the Shanghai and Hong
Kong stock exchanges; another link to the Shenzhen exchange is also in the
works. As part of making the yuan a more global currency, China is also opening
its bond market to institutional investors.

And some foreign banks want a
bigger foothold, believing that China’s growth prospects outweigh its risks.
International bank lending to Chinese residents in mid-2015 amounted to $1.2
trillion, close to an all-time high and more than three times the 2010 figure,
according to the Bank for International Settlements. HSBC, the biggest foreign
bank in China, considered shifting its global headquarters to Hong Kong earlier
this year, though in the end stayed put in London. Even those firms that want
to insulate themselves from China will find it difficult to resist the
gravitational pull of the world’s second-largest economy. “For serious
investors, it’s no longer optional to be here,” says Eugene Qian, China head
for UBS.

Many are still holding off,
believing that Chinese growth and the yuan have further to fall. But it is only
a matter of time before major benchmarks such as the MSCI world equity index
start to incorporate Chinese stocks and bonds. As that happens, funds from
university endowments in California to pension providers in Sweden will follow
their lead, adding onshore Chinese assets to their portfolios. Based on their
current trajectory, China’s capital markets could be the world’s biggest within
a decade. “Investors in America won’t be able to go to bed without knowing
where China is trading,” says Luke Spajic of the Asian arm of Pimco, a giant
fund manager. The pace may vary but the trend seems inexorable: Chinese and
global financial systems are becoming intertwined. With each passing year,
China’s problems will increasingly be the world’s problems.